The purpose of this series of posts is to demonstrate why we believe a total return approach is a better option than a pure income approach when investing to fund living expenses, particularly in a low-interest-rate environment. We hope that convincing investors of this will pay them dividends in the form of better returns.
In parts 1 and 2, we considered some of the pitfalls of investing in vehicles that primarily cast off income. So what is an investor to do if their primary need is income from their investments? Our approach has always been to try to generate the highest return without exceeding a client’s risk tolerance. We’ll talk more about how to build and manage portfolios, but first we’ll summarize the reasons we build portfolios with risk and return, as opposed to income, as our primary focus.
- Seeking the best return for a given level of risk lets us build better-diversified portfolios. This is especially important because there is always a range of potential economic and market outcomes, and no one can be sure how things will play out. We work hard to get a sense of probabilities and downside severity, but good diversification lets us build portfolios better suited to a variety of outcomes.
- A total return approach can be more tax efficient. Rebalancing to raise cash by trimming appreciated investments back to target levels can result in gains that are typically taxed at much lower rates than the ordinary income thrown off by an income portfolio. A further opportunity exists to offset gains by realizing losses when it makes sense to do so.
- An investor who is regularly withdrawing living expenses needs a portfolio that will provide for them far into the future. The term “capital sufficiency” refers to how long a portfolio will last at a given return and withdrawal rate (and, helping make our point, the source of return is irrelevant in computing this). All the while, inflation steadily erodes the value of those dollars. Trading return potential for the sake of current income makes the challenge of meeting financial goal even tougher.
Part 4 will address how we tackle this ‘total return’ approach and address issues such as distributions, taxes and perhaps most investors’ greatest concern, capital preservation.
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